Clarified Auditing Standard, Audit Evidence (AU-C 500)—Part 2: More Types of Tests

Analytical Procedures (AU-C 520)

Analytical procedures consist of absolute comparisons of dollar balances with prior years’ account balances, or with budgets, ratio comparisons and trend analysis, and computations based on financial or operational data designed to predict the balance in a general ledger account. Analytical procedures also extend beyond numerically-based procedures to become a part of an auditor’s thought process. Challenging financial information or the lack of such information that appears unusual, maintaining a positive, healthy skepticism when considering client responses to inquiries, and searching for the cause of a problem beyond its symptoms are examples of analytical thinking. The term “professional skepticism” is used in the literature to describe this kind of thinking. It is loosely defined as neither blindly trusting every client or, on the other hand, considering each client dishonest as information is gathered.

The most common analytical procedures are corroborative in their nature. Their primary purpose is to corroborate evidence gathered from other tests designed to enable an auditor to evaluate financial statement assertions.

When the results of analytical procedures contribute evidence to evaluate financial statement assertions, related tests of balances can be reduced at least to a limited extent. The extent of the reductions of tests of balances depends on the effectiveness of the analytical procedures. Determination of the effectiveness of a procedure must be based on the procedure’s contribution of evidence for evaluating the financial statement assertions. Computations designed to predict the balance in a general ledger account based on audited financial or operational data, e.g. quantity reconciliations and reasonableness tests, are the most effective analytical procedures. Corroborating procedures performed at lower levels of detail are more effective than corroborating procedures based on balances of financial statement classifications.

Examples of analytical procedures, in the order of their effectiveness, are:

1.      Quantity reconciliations:

Multiplying the number of units sold times sales price or the number of employees times weekly or monthly salaries, for example, can contribute evidence that will enable an auditor to evaluate substantially all the financial statement assertions for the applicable general ledger account. Only a few other tests of balances would ordinarily be necessary for the affected accounts if the data used in the computations has been audited.

To achieve maximum effectiveness, the reliability of the underlying data for these procedures must be established by other tests. For example, performing a quantity reconciliation for copy sales by a quick-copy business would simply require multiplying the number of copies sold times sales price. The number of copies could be obtained from the client’s copy log; however, beginning and ending numbers from the meter would need to be physically obtained to establish the reliability of the log. To determine the meter had not been altered, it may also be necessary to trace the number of copies to billings for copy machine rentals from the supplier. Copy prices would have to be determined by references to sales tickets or price lists.

2.       Reasonableness tests:

Depreciation computations performed by computing depreciation by financial statement classification and method, based on average lives and one-half year for additions and disposals, is an example of a reasonableness test. Computing interest expense based on average note balances and interest rates is another example.

Different from quantity reconciliations, reasonableness tests are based on averages and estimates. Reasonableness tests are not as effective as quantity reconciliations in providing evidence to evaluate financial statement assertions. Since they are usually applied to smaller account balances, however, other tests of balances may not be necessary. Other limited tests of controls or balances may be necessary to complete the evaluation of the relevant assertions for material balances.

3.      Corroborating procedures:

The most common analytical procedures, such as absolute dollar comparisons of account balances and ratio analysis, provide evidence that corroborates other tests of controls and balances. While using corroborating analytical procedures may enable some modification of the nature, extent and timing of tests of balances procedures, more tests of balances procedures will ordinarily be necessary for satisfactory evaluation of the financial statement assertions.

The lower the level of detail of the corroborating procedures, the more effective they are. Gross profit margin computed by product line, for example, is more effective than when computed using amounts in financial statement classifications. Risks of material misstatements, in other words, are more easily identified using corroborating procedures at lower levels of detail.

SAS No. 56, redrafted in AU-C 520, Analytical Procedures, instructs auditors to perform analytical procedures during the planning phase of an engagement to help identify potential risks of misstatements. SAS No. 109, redrafted in AU-C 315, re-emphasizes the use of analytical procedures as risk assessment procedures. Analytical procedures should also be used during the review phase of an engagement to evaluate the results of an auditor’s completed work.

Minimum analytical procedures performed during planning may consist of comparing material unadjusted, current year account balances with prior year final balances. Significant variances usually indicate the need for adjusting journal entries. These differences should be investigated, documented in the working papers and, if necessary, adjustments proposed to correct errors or post year-end adjustments.

Placing high reliance on corroborating or predictive procedures requires, simply, that all variances are investigated and appropriate corrective action is taken by an auditor. From the investigation, the auditor may determine that the variance is not indicative of a problem or, on the other hand, that it is caused by an error or conditions that could cause errors in financial information. The auditor may, or may not, determine adjustments are necessary.

If analytical procedures can be performed extensively for high reliance during planning, related tests of balances procedures should be reduced. If extensive analytical procedures cannot be performed until engagement completion, as in the case of small clients with weak accounting systems, past experience can be relied upon to anticipate favorable results and plan for reductions in tests of balances. To repeat this significant time-savings opportunity, reductions in tests of balances evidence may be achieved by placing high reliance on analytical procedures performed during the risk assessment process.

Tests of Balances

Substantive tests of the details of general ledger account balances include the following:

·        Physical examination of assets.

·        Confirmation of account balances.

·        Inspection of support for transactions and balances.

·        Observation of the work of client personnel.

·        Inquiries of client personnel.

·        Tests of the mechanical accuracy of balances.

The substantive tests of balances make the most substantial contributions of evidence for evaluating the financial statement assertions. The larger the engagement, the higher the costs of obtaining most evidence from the tests of balances will likely be. When the client has good internal control procedures or a good accounting system, high reliance on tests of balances may not be the most efficient audit strategy. On some engagements, auditing in the least amount of time may best be accomplished by a combination of evidence from risk assessment procedures including tests of controls and/or systems walk-through procedures, analytical procedures and tests of balances. The auditor should always endeavor to design an audit strategy that produces necessary evidence in the least amount of time.

More Information

These eBook resources, without CPE credit, can be obtained from my website, www.cpafirmsupport.com :

• Small Audits Made Easy and Profitable
• Performing Auditing Tests of Balances Procedures
• Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
• Key Accounting Issues for Non-Profit Organizations
• A Practical Potpourri of Time Savings on Audits
• The Financial Reporting Framework for Small- and Medium-Sized Entities

My exclusive presentation of webcasts on CPE Credit.com and self-study courses covering various applications of auditing standards can be accessed by clicking the appropriate box on the left side of my home page, www.cpafirmsupport.com. Registered users accessing webcasts or self-study courses on my website receive a 20% discount on CPE materials presented by myself and numerous other authors on a variety of professional topics.

My assistance in CPA firm quality control consulting, audit planning and peer review preparation can be obtained by sending an email using the “Contact Us” tab on my home page.

Clarified Auditing Standard, Audit Evidence—Part 1 (AU-C 500)

AU-C Section 500 describes the sufficiency and appropriateness of audit evidence in the following paragraphs

.A4 Sufficiency is the measure of the quantity of audit evidence. The quantity of audit evidence needed is affected by the auditor's assessment of the risks of misstatement (the higher the assessed risks, the more audit evidence is likely to be required) and also by the quality of such audit evidence (the higher the quality, the less may be required). However, obtaining more audit evidence may not compensate for its poor quality.

.A5 Appropriateness is the measure of the quality of audit evidence (that is, its relevance and reliability in providing support for the conclusions on which the auditor's opinion is based). The reliability of evidence is influenced by its source and nature and is dependent on the individual circumstances under which it is obtained.

General types of audit procedures are also discussed in this statement:

.A10 As required by and explained further in section 315 and section 330, audit evidence to draw reasonable conclusions on which to base the auditor's opinion is obtained by performing the following:

a. Risk assessment procedures

b. Further audit procedures, which comprise

i. tests of controls, when required by the AU-C sections or when the auditor has chosen to do so, and

ii. substantive procedures, which include tests of details and substantive analytical procedures.

A Brief Discussion of Basic Types of Tests

To build the foundation for designing the most cost-beneficial audit strategies, a thorough knowledge of the basic types of tests recognized in AU-C 500 is necessary.

Tests of Controls—Compliance Transactions Tests (author’s words)

Compliance tests are designed as tests of internal control procedures or activities to determine:

1.      The frequency with which the control procedures are performed.

2.      The quality of the performance of the control procedures.

3.      The person performing the procedures.

4.      The design effectiveness of the procedures.

Compliance tests of controls are performed to measure the likelihood of errors occurring and going undetected and to reduce the amount of substantive testing. Compliance procedures consist mainly of observations, inspections and inquiries. Documented evidence of the internal control procedures performed by a client personnel is necessary to evaluate compliance for larger entities with effectively designed internal controls. Examining a foreperson’s approval of hours worked on employees’ time cards, for example, is a compliance test of control. Materiality is measured by the frequency of errors.

Owners or managers for small entities may perform key controls that are not documented. In these circumstances, the auditor can assess compliance by making inquiries of an owner or manager, evaluating their responses, and documenting their compliance in a memo or on a working paper.

Tests of Controls—Substantive Transactions Tests (author’s words)

A substantive transactions test is a test of the accounting system and is normally designed to test for monetary errors. Determining that all entries recorded in the cash disbursements journal are valid by examining supporting documents, or that the extension of sales prices and units on sales invoices are correct, are examples of substantive transactions testing procedures. Tests of controls are often used as “dual-purpose” tests, i.e., both compliance and substantive tests of transactions are performed. While both may supply sufficient evidence for evaluation of applicable financial statement assertions, auditors can be more efficient by performing one or the other. Only a “handful” (10%-20%) of the transactions need be tested substantively if compliance tests are chosen.

If a client has limited internal controls, but has a solid accounting system, an auditor may perform only substantive transactions tests or make an assessment of control risk using other procedures such as a systems walk-through procedure, or tests of an owner/manager’s key controls by making inquiries and/or observations of procedures and inspection of documents.

System’s Walk-Through Procedure

The system’s walk-through procedure is often the most cost-efficient, annual risk assessment procedure auditors can use, and is discussed in the auditing standards. It is performed by tracing documents and data through the accounting system from the inception of transaction cycles to their termination. Its primary purpose is to provide a good understanding of the accounting system and any control procedures or activities for risk assessment purposes. Ordinarily 5-10 transactions will be selected for this purpose; selecting more transactions will increase the substantive evidence from this procedure.

The walk-through procedure, coupled with good prior year experience with a client and evidence from reading general ledger account activity, may permit an assessment of control risk at slightly less than high to moderate. An auditor may be able to use lesser reliable procedures (nature) for small details of an account balance, lesser audit coverage of an account balance (extent), and/or perform some procedures before year-end (timing) at these lower risk levels. This procedure, considered along with other risk assessment procedures, can provide substantive evidence that enables the auditor to plan an audit strategy that reduces tests of balances procedures.

Reading (Scanning) the General Ledger 

One of the most pervasive analytical procedures is reading, or scanning, the general ledger account activity. Whether done manually, or with the assistance of data extraction software, this analytical procedure is discussed for the auditing standards.

Many auditors perform this procedure but fail to consider its affect on their audit strategy. After any errors are corrected by proposed journal entries, the auditor has obtained significant, substantive evidence that relevant assertions for many account balances are reasonable. The evidence obtained from this risk assessment procedure should enable the auditor to reduce the assessed level of risk of material misstatement and, therefore, the extent of evidence desired from detailed tests of balances.

This procedure is usually performed by looking for unusual amounts or postings, transactions or general journal entries greater than the lower limit for individually significant items, checks or disbursements to be used in support tests, and other unusual matters. Documentation of the procedure should include the parameters of the test, the exceptions the test revealed and the resolution of the exceptions in a spreadsheet, memo or other working paper. Other modules of this small audit series discuss a General Ledger Analysis Worksheet (an Excel spreadsheet) as the most efficient documentation for listing and following up on unusual matters.

AU-C 620, Using the Work of an Auditor’s Specialist, differs from the previous AU section only in that management’s specialists’ issues are discussed in the Clarified Auditing Standard on quality control.  The auditor has responsibility to evaluate the reputation of any specialist used in and audit and the auditor must have at least a general knowledge of the processes used by the specialist.

Analytical procedures and tests of balances will be discussed in Part 2 of this article.

More Information

These eBook resources, without CPE credit, can be obtained from my website, www.cpafirmsupport.com :

• Small Audits Made Easy and Profitable
• Performing Auditing Tests of Balances Procedures
• Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
• Key Accounting Issues for Non-Profit Organizations
• A Practical Potpourri of Time Savings on Audits
• The Financial Reporting Framework for Small- and Medium-Sized Entities

My exclusive presentation of webcasts on CPE Credit.com and self-study courses covering various applications of auditing standards can be accessed by clicking the appropriate box on the left side of my home page, www.cpafirmsupport.com. Registered users accessing webcasts or self-study courses on my website receive a 20% discount on CPE materials presented by myself and numerous other authors on a variety of professional topics.

My assistance in CPA firm quality control consulting, audit planning and peer review preparation can be obtained by sending an email using the “Contact Us” tab on my home page.

Clarified Auditing Standard--Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained (AU-C 330)

Risk Assessment and Responses to Assessed Risks

This standard requires the auditor to design and implement overall responses for the assessed risks of material misstatement at the financial statement level. Overall responses at higher levels of risk may include assigning more experienced personnel to the engagement, providing increased supervision by the engagement leader and planning more reliable and more extensive detailed tests of balances procedures.

Audit Procedures Responsive to the Assessed Risks of Material

Misstatement at the Relevant Assertion Level

Following are essential requirements from AU-C 330 paragraphs:

.06 The auditor should design and perform further audit procedures whose nature, timing, and extent are based on, and are responsive to, the assessed risks of material misstatement at the relevant assertion level.

.07 In designing the further audit procedures to be performed, the auditor should

a. consider the reasons for the assessed risk of material misstatement at the relevant assertion level for each class of transactions, account balance, and disclosure, including

i. the likelihood of material misstatement due to the particular characteristics of the relevant class of transactions, account balance, or disclosure (the inherent risk) and

ii. whether the risk assessment takes account of relevant controls (the control risk), thereby requiring the auditor to obtain audit evidence to determine whether the controls are operating effectively (that is, the auditor intends to rely on the operating effectiveness of controls in determining the nature, timing, and extent of substantive procedures), and

b. obtain more persuasive audit evidence the higher the auditor's assessment of risk.

Practical Considerations for Audit Responses

Selecting the Audit Strategy:

To select the proper strategy and prevent over auditing, the auditor must consider (1) the opportunity to assess risk of material misstatement at less than high and (2) the relative efficiency with which substantive tests of balances procedures can be performed.  When a reporting entity has good internal controls and/or a good financial reporting system, using tests of controls may be the most cost-efficient strategy.  However, when an auditor can perform other risk assessment procedures on smaller audits, e.g., reading the general ledger and performing a systems walk-through procedure and then making at least slight reductions in substantive tests of balances to evaluate applicable financial statement assertions in minimum time, detailed tests of controls would not ordinarily be necessary.  

Since the evaluation of the risk of material misstatement is made at both the financial statement and the assertion levels, and because performance materiality (tolerable misstatement) must be determined for each material financial statement classification, the auditor may achieve efficiencies by planning unique audit strategies for each financial statement classification.

Effects of Inherent Risks:

As an auditor considers the design of an audit strategy, it is important to remember the higher the inherent risk in a transaction or balance, the higher the reliance normally required for tests of balances procedures. However, it is the combination of inherent risk and control risk that determines the assessed levels of RMM.  Tests of controls or systems walk-through procedures may provide evidence to mitigate higher inherent risks in account balances or classes of transactions.

Effects of Control Environment on Control Risk:

The more effective an entity’s control environment is, the lower the control risk.  The lower the control risk, the lower the necessary reliance on detailed tests of balances.  A more effective control environment normally results in a stronger financial reporting system and even effective owner or manager key controls, particularly on smaller audits.  A less effective control environment normally results in deficiencies in the design and operation of internal control activities.

Effects of Low-Reliance Tests of Controls or Systems Walk-Through Procedures:

Deciding to perform low-reliance tests of controls, other risk assessment procedures and/or system’s walk-through procedures when an entity has a good financial reporting system and control environment may permit an evaluation of risk of material misstatement at slightly less than high to moderate, even on smaller audits.  When risk of material misstatement is slightly less than high or moderate, the extent of some sampling and non-sampling procedures may be reduced.

These limited reductions of tests of balances will generally occur by:

• Raising the lower limit for individually significant items from approximately 10% of performance materiality (high risk) up to 50-60% for financial statement classifications or relevant assertions.
• Using less reliable procedures for the lower stratum in a sampling population, such as sending negative confirmations for small accounts receivable balances.
• Risk factors on a sampling planning and evaluation form can be reduced somewhat.  Without good prior experience with the client, and without significant substantive evidence from analytical procedures, the risk factor would be close to 3.0.  These factors remaining the same and control risk at slightly less than high or moderate may allow a risk factor of from 2.3 to 3.0.
• Certain detailed tests of balances procedures may be performed before the reporting date.  Accounts receivable, for example, may be confirmed up to 30 days before the engagement date, along with performance of appropriate roll-forward procedures.

Effects of Analytical Procedures:

The more effective the analytical procedures used, the lower the amount of evidence required from detailed tests of balances.  High reliance presumes using analytical procedures to the maximum extent practical to generate substantive evidence to evaluate financial statement assertions. Quantity reconciliations, such as the number of units sold times sales price, or reasonableness tests for such accounts as depreciation, interest or payroll taxes generally produce more substantive evidence than corroborative procedures like comparing account balances or ratios among years.

Evaluating the Completeness Assertion:

When detailed tests of balances or analytical procedures can be performed to efficiently evaluate the completeness assertion, tests of controls are not necessary for this purpose.  Evaluating the completeness of revenues through detailed tests of balances, however, is difficult at best.  Examples of tests of balances that can be used to produce substantive evidence to evaluate the completeness assertion for revenues include examining contracts to determine all revenues that should be recorded are recorded (for the construction industry) or using predictive analytical procedures to determine the accuracy of recorded revenues or expenses, e.g., using copy machine meter readings for a copying business to compute copying revenues and copy machine rental expense. 

In other instances, limited tests of controls may be necessary to evaluate the completeness of revenues.  Tracing, say, 15 documents originating sales transactions such as customer orders or shipping reports to the sales journal is an example of a limited test of control procedure for completeness.  In some moderate risk circumstances, tracing 10-15 transactions through the sales and collections transaction cycle during the systems walk-through procedure may produce sufficient evidence to evaluate the completeness assertion.  Higher risk may require more transactions.

Nature, Extent and Timing of Detailed Tests of Balances:

Reductions in detailed tests of balances will occur in the nature, extent and timing of the procedures.  Ultimately, the integration of the results of the risk assessment procedures, the results of the analytical procedures and the nature, extent and timing of tests of balances procedures will culminate in audit strategies for account classifications as an auditor designs and performs sampling and non-sampling procedures.  The Clarified Auditing Standard, Audit Sampling, will be discussed later in this series.

More Information

These eBook resources, without CPE credit, can be obtained from my website:

• Small Audits Made Easy and Profitable
• Performing Auditing Tests of Balances Procedures
• Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
• Key Accounting Issues for Non-Profit Organizations
• A Practical Potpourri of Time Savings on Audits
• The Financial Reporting Framework for Small- and Medium-Sized Entities